Bordering the Caspian Sea Azerbaijan is capitalizing upon the Sea's sizeable, but still mostly untapped, hydrocarbon resources. Azerbaijan's real gross domestic product (GDP) grew by an impressive 31 percent in 2006, driven by growth in oil production and the beginning of natural gas production. In the next couple years favorable real GDP growth is expected, but maintaining low inflation rates as energy and transit revenues flow into the country represents a major challenge. Azerbaijan's hope for sustained economic growth rests in large part with its management of sizeable oil and natural gas resources in the Caspian Sea region, through effective management of the resulting revenue stream, and non-oil sector diversification.

After the first commercial oil flows through the Baku-T’bilisi-Ceyhan pipeline (BTC) during summer 2006 and the increasing oil production from the Azeri-Chirag-Guneshli (ACG) project, oil revenues are expected to contribute to a doubling of Azerbaijan’s GDP by 2008. Although the oil sector represented around 10 percent of Azerbaijan’s GDP in 2005, it is already projected to double to almost 20 percent of GDP in 2007 (See Table 1). To manage the revenues, former president President Heydar Aliyev created a State Oil Fund in 1999, which is designed to use money obtained from oil-related foreign investment for education, poverty reduction, and efforts aimed at raising rural living standards. As of the end of 2006, the State Oil Fund reported assets of almost $2 billion, but the fund’s assets are expected to increase exponentially to $36 billion by 2010. See a recent paper in Geopolitics of Energyfor more information on the effects of energy revenues on Azerbaijan.

Economists at the IMF warn Azerbaijan that institutional reform and economic liberalization are necessary for the country to sustain its upcoming oil wealth. As oil revenues have increased, the government has increased spending. In combination with an accommodating monetary policy, these factors have led to rising inflation. In upcoming years, how the country manages these oil revenues will affect the livelihood of its population and the state of its non-energy economy. According to the International Monetary Fund (IMF), almost 45 percent of the population lives below the poverty line.

One significant challenge to president Ilham Aliyev's government is maintaining good relations with Azerbaijan's neighboring states. One source of conflict is the dispute over Nagorno-Karabakh. The conflict grew into a full-scale war that led to the death of over 22,000-25,000 people on both sides. As a result of Azerbaijan’s armed conflict with Armenia from 1988–1994, around 12 percent of Azerbaijan’s 8.3 million people became refugees and internally displaced persons (IDPs). While Baku and its environs have been the recipient of high levels of foreign direct investment (FDI) in recent years, the Western regions have the lowest levels of income and the highest incidence of poverty. As a result of a 1994 cease-fire, Azerbaijan lost approximately 16 percent of its former territory. Lingering tensions between the two countries remain, which raises concerns for stability and energy security in the area. For more information see: U.S. Department of State Fact Sheet on Nagorno-Karabakh and a background paper from the International Crisis Group.).